Unformatted text preview: Everything You Wanted to Know About Bonds and Their Value Everything You Wanted to Know About Bonds and Their Value 131 What are bonds?
• Yost Corporation wants to borrow money, and it decides to issue bonds. Each bondholder lends the firm money today for 30 years at 12 percent interest. Yost Corporation pays each bondholder $120 per year and returns the principal ($1,000) back to the bondholder at the end of the 30 years.
132 Bond Terms
• Coupon: The stated interest payment made on a bond.
• Face Value: The principal amount of a bond that is repaid at the end of the term. Also called ___________.
• Coupon Rate: The _______coupon divided by the face value of a bond. 133 FINC 3610 ‐ Yost Everything You Wanted to Know About Bonds and Their Value More Bond Terms
• Maturity: Specific date on which the principal amount of a bond (i.e., the face value) is repaid.
• Yield to Maturity (YTM): The rate required in the market on the bond. Also called the yield. This will be the “r” we use to calculate price and is quoted as ________. This is often not the same as the coupon rate.
134 Calculating the Price of a Bond
• How do we calculate the price of a bond?
• The price of a bond is equal to the __________ ________ of the bond’s __________ _______________. 135 Pricing Coupon Bonds
• Tigers, Inc. decides to issue $1,000 bonds with 5 years to maturity. The coupon rate is 10 percent, paid annually. The yield to maturity is also 10%. What is the price of a Tigers, Inc. bond?
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• Now, assume the yield to maturity (i.e., the market interest rates) rises to 12 percent. What is the price of the bond now? 0 1 2 3 4 5
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• Now, assume the yield to maturity (i.e., the market interest rates) falls to 8 percent. What is the price of the bond now? 0 1 2 3 4 5
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• Assume the yield to maturity is 10 percent. What is the price of the bond if the coupon payments were made semiannually? 0 1 2 3 4 5
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• You just purchased a DocYost, Inc. bond for $1,050. The bond has a $1,000 face value and an 8% coupon rate, paid semiannually. The bond matures in 10 ½ years. What is its yield to maturity? 140 Current Yield
• Current Yield: ________coupon divided by current price.
• What it is:
• What it is not: 141 Another Example
• There are two $1,000 bonds identical in every way (i.e., same risk) except for their coupons and their prices. Both have 3 years to maturity and annual coupons. The first has an 8 percent coupon rate and sells for $974.69. What is its yield to maturity (YTM)? • The second bond has a 10 percent coupon rate. If it has the same YTM as the first bond, what is its price?
• Which is better? FINC 3610 ‐ Yost 142 Everything You Wanted to Know About Bonds and Their Value What about zero‐coupon bonds?
• What are they?
• How do I calculate their price?
• What is the price of a zero‐coupon bond that has a face value of $1,000 and matures in 10 years, if the YTM is 8%?
143 Interest Rate Risk
• Interest Rate Risk: The risk of a change in the value of a bond because of a change in the interest rate.
1. Bond prices and market interest rates move in _____________ directions.
2. All other things being equal, the longer the time to maturity, the _______ the interest rate risk.
3. All other things being equal, the lower the coupon rate, the _______the interest rate risk.
144 Other Bond Pricing Truths
• When a bond’s coupon rate is _______ than the YTM (market’s required return), the bond’s price (market value) will be greater than its par value.
• When a bond’s coupon rate is _______ the YTM (market’s required return), the bond’s price (market value) will be equal to its par value.
• When a bond’s coupon rate is ___ than the YTM (market’s required return), the bond’s price (market value) will be less than its par value. 145 FINC 3610 ‐ Yost Everything You Wanted to Know About Bonds and Their Value The Term Structure of Interest Rates
• Term Structure: The relationship between interest rates and time‐to‐maturity of a debt security.
• Yield on Bonds
– Real Interest Rate
– Inflation Premium
– Interest Rate Risk Premium
– Default Risk Premium
– Liquidity/Marketability Premium
146 Bond Features
• Indenture: The written agreement between the corporation and the lender detailing the terms of the debt issue.
• Terms of a Bond
147 Bond Features
– Sinking Fund • Call Provision
– Call Premium
– Yield‐to‐Call • Protective Covenants FINC 3610 ‐ Yost 148 Everything You Wanted to Know About Bonds and Their Value Differences Between Debt and Equity
– Not an ownership interest
– Creditors do not have voting rights • Equity
– Ownership interest
– Common stockholders vote for the board of directors and other issues – Interest is considered a cost of doing business and is tax deductible
– Creditors have legal recourse if interest or principal payments are missed – Dividends are not considered a cost of doing business and are not tax deductible – Excess debt can lead to financial distress and bankruptcy – An all equity firm can not go bankrupt – Dividends are not a liability of the firm and stockholders have no legal recourse if dividends are not paid 149 Suggested Problems
• Concepts Review and Critical Thinking Questions
– 1, 3, 6, and 8 • Questions and Problems:
– 2, 3, 4, 5, 15, 17, 18 (effective annual yield is the EAR), 19, 23, 26 (only parts A and B), and 29.
150 Example #1
• I just purchased a $1,000 zero‐coupon bond that matures in 8 years. If the yield‐
to‐maturity is 6.5%, how much did I pay? 151 FINC 3610 ‐ Yost Everything You Wanted to Know About Bonds and Their Value Example #2
• You are considering purchasing a $1,000 Simba Inc. bond at par. The bond has a 10% coupon rate, paid semiannually, and matures in 4 years. What is its YTM? 152 Example #3
• Gizmo Enterprises is issuing 10 year bonds with a face value of $1,000. The coupon rate is 10%, paid semiannually. What is the price of the bond if the YTM is 8%? 153 Example #4
• Zach Corporation bonds are selling for $1,386.09. They have a face value of $1,000 and a current yield of 7.2145%. If the YTM is 5%, interest is paid annually, and the bond has 10 years to maturity, what is the coupon rate? 154 FINC 3610 ‐ Yost ...
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